The Great Disconnect
September 30, 2008
Market Summary – 3rd Quarter, 2008
We cite this statement by Louis Rukeyser as a reminder that we have passed this way before. The events described above, from 25 years ago, presaged today’s environment. Nine of the largest U.S. banks were saddled with bad loans to the then economic upstarts Mexico, Argentina and Brazil. The debt was 25% greater than the combined net worth of those nine banks.
It is ironic that the President of Brazil recently was quoted as saying “It’s not fair for Latin American, African and Asian countries to pay for the irresponsibility of sectors of the American financial system.” But in truth, we are all paying for it – individual investors, workers who will lose their jobs due to the seemingly inevitable economic downturn, and people living in economies across the globe.
We wonder if banks and Wall Street will ever learn their lessons. They obviously have very short memories. Again today, large firms have been left holding bad debt, and again, it threatens the entire global economy.
A “Fire Sale” For the Ages
The rate at which the current downturn has unfolded is dramatic and has reached levels that can be considered a disconnect from reality. This table shows how the bears have gained speed through the summer and so far into the fall (through October 10):
* Intraday value, not closing price.
From September 26th through October 10th, the Dow Jones Industrial Average lost more than 24% of its value. It took just ten trading days for that to occur.
What can explain such a destructive environment? While a lack of confidence in the financial system underpins much of what is going on in the markets, the dramatic sell-off of recent weeks is an indication of something far more simple – large institutions, mainly hedge funds – are being forced to liquidate large, leveraged positions at any price. It is, in effect, a margin call on the hedge fund industry. Adding to the decline was the SEC’s 2007 elimination of the uptick trading rule (requiring short sale of a stock to occur only when the last trading price of the stock was higher than its previous price). This allowed short sellers to pile on individual stocks, driving them further down in value.
The price disconnect is exemplified by what has happened to gold stocks. In the 3rd quarter, while the price of gold declined just 5.6%, gold stocks (in the S&P 500) lost 25.7% of their value. The erosion of gold stock values belies a reality in the market. Call any gold dealer in the country to see if you can actually buy the metal in coin form or other tangible ways, and you will be hard pressed to find any. Actual supply-demand activity in today’s gold market is not being reflected in prices of gold-related companies.
Significant problems exist in the current economy. But a 24% decline over a ten-day trading period hardly reflects reality. It is a demonstration that forced liquidation has created an environment for equities that is far out of proportion to the underlying reality.
The multi-trillion dollar question is “when will the selling stop?” That’s impossible to predict. It seems safe to say that the end of this fire sale mentality is near, and we expect that before long, the last share of a forced liquidation will have been traded.
What’s left are a number of companies that have generated significant wealth over the years, now priced at incredibly low levels. Their current stock values are justified only if you believe that the global economic system will not be able to recover. Where do we go from here?
“I’ve Never Seen A Monument Erected to a Pessimist”
The eternal optimist Paul Harvey is credited with this quote. It is well worth remembering at times like these. The late, great value investor Sir John Templeton also made the observation that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” The only question now is how far along we are in the pessimism process. It is when pessimism is at its peak that opportunity is at its best. Even if there is more pessimism to go, it is clear that we have come a long way just in the last six weeks.
Warren Buffet, another great value investor, has been putting his money where his mouth is. On Public television’s “Charlie Rose” program in early October, Buffet reiterated his famous bromide, “when others are greedy, be fearful. When others are fearful, be greedy.” Buffet is hardly downplaying the current crisis, calling it an “economic Pearl Harbor.” But his greedy side is coming out more and more, with recent multi-billion dollar investments in Goldman Sachs and General Electric.
Said Buffet, “I will tell you this. This country (will) be living better ten years from now than it is now. It will be living better in 20 years from now than ten years from now.” The oracle goes on to say that he knows it will take time to turn things around, maybe six months or maybe two years. He adds, “we’ve got more productive capacity now than we ever have. The American worker is more productive than he’s ever been. We’ve got more people to do it. We’ve got all the ingredients for a sensational future.”
The optimism that our economy will regain its footing, is critical to investment success. It is a perspective that keeps investors confident even in the worst of times. Put today’s crisis in an historical context. This country survived a civil war, two World Wars, the Great Depression, the Cold War, oil shocks and various other calamities in between. Yet the markets continued to find ways to create great wealth.
What we see today is opportunity like nothing that has existed in decades. Here are a few facts for perspective:
- The S&P 500 has declined 42.55% in the 12 months. By comparison, the S&P 500 lost 33.24% in 1987 from its peak through the worst of the crash and 45.93% from peak to trough during the bear market in 1973-74. The last time the market (Dow Jones Industrial Average) declined by 50% was back in 1937.
- There is $11.5 trillion in money sitting on the sidelines. These are funds in checking and savings accounts and money market funds, as well as in U.S. Treasuries. Typically, we see about $8 trillion sitting in “cash,” but the number has held at a much higher level in recent years.
- After the market’s close on October 10, according to The Wall Street Journal (October 11, 2008), 38% of stocks are now trading at less than eight times their past year’s earnings.
The numbers tell us that the pessimism Sir John Templeton talked about is in strong supply right now. The short interest on the New York Stock Exchange is one piece of evidence. The short interest ratio, essentially a sentiment indicator, is hovering around record levels. The NYSE reported on July 15 that the short interest ratio reached a record of 4.86 (meaning, in theory, that it would take nearly 5 days worth of trading to cover the value of all of the shares shorted). That is about double what the number was two years ago.
Given the magnitude and speed of the recent selloff, it seems entirely possible that when a rally occurs, it could be sudden.
A good example of how quickly things can turn is 1974, the last time the nation faced a significant credit/liquidity crunch. At that time, investors were forced to sell stocks due to a shortage of cash and limited credit sources caused by an uncooperative Federal Reserve. That is a major distinction from today’s crisis, where the Fed has been very accommodating and trillions of dollars in cash is sitting on the sidelines. It is interesting to note that the Dow Jones average bottomed at 577 in December 1974. By March 1976, just 15 months later, the Dow topped 1,000 (a 73% gain) a good demonstration of just how quickly things can turn around.
A realistic assessment
Though the market offers tremendous values, any realistic assessment must acknowledge that:
- The environment will remain volatile.
- The “credit crunch” will take some time to resolve.
- A number of negative developments will ensue, such as more job losses, less consumer spending and higher rates of home foreclosures.
These are among the many big problems that must be resolved. Some of it will happen with government intervention to speed things along or help limit the damage. Much of it will just have to unwind as part of a normal economic cycle.
History and our experiences leave us with a few notable impressions:
Too much debt is a bad thing. The disappearance of financial icons like Bear Stearns, Merrill Lynch and Lehman Brothers and the apparent high rate of redemptions at hedge funds tell us the inherent problem with heavy debt as part of an investment strategy – it forces one to “live in the moment.” The short term was everything, at the expense of seeing the bigger picture. Executives were playing for the big bonuses, and the risk of being wrong was transferred to shareholders. The Wall Street mentality became one of trading and speculating, rather than investing in the world. Recent events might bring the markets back to reality, a positive development for investors.
Financial agencies worldwide are transcending politics to resolve the problem. The U.S. government and the Federal Reserve have approved more than $3 trillion in lending authority, and it is clear the spigot will be opened as wide as it needs to be to assure that our financial system works. It appears that not just the U.S. government, but those of other countries as well as international organizations like the IMF, G-7, G-20 and the World Bank will not sit idly by as the situation deteriorates. From an ideological perspective, that may be troubling, but speaking pragmatically, it must be done, and the economy and investors will ultimately benefit from proper government intervention in this unique time.
Energy represents the “next great crisis.” Lower oil prices today are a welcome development. But don’t get too used to it. If a slower economy keeps prices down for now, the trend cannot hold. Remember that demand is increasing as huge countries like China and India and many smaller nations grow their middle class. Oil demand will continue to trend higher, and that will create attractive opportunities for investment, not just in oil-related companies, but those involved in other types of energy production.
Things will get better. This may be difficult to see given the smoke rising from Wall Street. New opportunities are always created in crises. The timing is hard to predict, but the more the bear market is extended, the more realistic a market rebound becomes.
All companies are not equal. It is necessary to find the right companies to benefit from the market rebound and continued growth.
Surely events today are unique in their own way. However, every crisis of the past involved unpredictable circumstances. Fortunately, after each previous event, markets recovered and eventually went on to new highs. It will happen again.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.